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Block trades captivated Wall St on Friday, leaving focus on remaining exposure at private investment firm

Archegos Capital, a private investment firm, was behind billions of dollars worth of share sales that captivated Wall Street on Friday — a fire sale that has left traders scrambling to calculate how much more it has to offload, according to people with knowledge of the matter.

The fund, which had large exposures to ViacomCBS and several Chinese technology stocks, was hit hard after shares of the US media group began to tumble on Tuesday and Wednesday.

The declines prompted a margin call from one of Archegos’ prime brokers, triggering similar demands for cash from other banks, said people familiar with the matter. Traders buying the large blocks of stock were told the share sales had been prompted by a “forced deleveraging” by a fund.

Archegos is a family office that manages the wealth of Bill Hwang, a “Tiger cub” alumnus of Julian Robertson’s legendary hedge fund Tiger Management.

The firm’s website is no longer available and the company did not return multiple requests for comment. The fund’s head trader in New York hung up the phone when contacted by the Financial Times.

New York-based Hwang previously ran the Tiger Asia hedge fund but he returned cash to investors in 2012 when he admitted wire fraud relating to Chinese bank stocks.

Hwang paid $44m in fines to settle illegal trading charges with the Securities and Exchange Commission in 2012, and in 2014 he was banned from trading in Hong Kong. He did not respond to multiple requests for comment. 

The sales on Friday knocked about $33bn of value off the companies involved, including Chinese tech stocks and US media groups, as Goldman Sachs and Morgan Stanley sold blocks of shares worth $19bn at discount prices throughout the day. Other funds may also have joined in the selling, people familiar with the trades say

Archegos manages its own money and does not have outside investors but its pressing need to offload large stakes in several companies is sending ripples across stocks in Asia and elsewhere, inflicting losses on other holders of the shares. 

For those other investors, the question now is whether the fire sales are over. Some traders say the pattern of recent selling, which ran for several days but reached a peak on Friday, suggests the bulk has been completed. Others think the scale of leverage that Archegos appears to have used means billions of dollars' worth of positions could still remain to be sold.

Archegos describes itself as a “purposeful community of investment industry professionals”, according to an archived version of its website. 

Its name is a biblical Greek word meaning chief, leader, or prince, used in relation to Jesus. In a 2018 YouTube video, Hwang said his investments were “not all about money”, adding that “God certainly has a long-term view”. 

“We love seeing in our little eyes what God is doing through investing and capitalism and how . . . it can be done better,” he said. 

Stimulus could jolt inflationary pressures back to life, top hedge fund manager warns

The retail stock trading frenzy will reach a new crescendo in the coming weeks thanks to the US government’s stimulus cheques but the inflation this support could ignite represents a threat to the stock market bull run, according to Citadel’s Ken Griffin.

The founder of one of the world’s biggest hedge funds thinks the $1,400 sent out to millions of Americans this month is likely to fuel another spasm of retail trading before activity settles down to a still-elevated level. Amateur trading would remain a powerful feature in US equities, he said.

However, in a rare interview with the Financial Times, Griffin warned that huge amounts of central bank bond-buying and government spending could jolt US inflation out of its decades-long torpor and unsettle financial markets just as they were attracting more retail involvement.

“Given the incredible amount of stimulus that has been unleashed, there is a possibility we see a real surge in inflation,” Griffin said. “The question is whether it is transitory or becomes permanent and structural, and there is a much higher chance that it becomes entrenched than any other time over the past 12 years.”

On the whole, Griffin says he is optimistic on the outlook, and hailed the retail trading boom as a way for more Americans to benefit from the US stock market. But he warned of a doomsday scenario win which accelerating inflation deepens a bond market sell-off, sends stocks tumbling and stokes unrest among retail investors hurt in the process. 

Fears over inflation are growing across the investment industry, with accelerating price gains and a bond market “tantrum” highlighted as the biggest risks that markets now face in Bank of America’s latest monthly survey of investors. The percentage of investors expecting faster inflation over the coming year in March hit the highest since at least 1995, when the survey began.

Citadel is one of the hedge fund industry’s largest players, managing about $34bn. Its flagship fund returned 24.4 per cent last year despite the turbulent markets, and this year it was up about 5.2 per cent to the end of February, according to people familiar with the matter. Over the fund’s 30 years it has averaged annual gains of 19 per cent, burnishing Griffin as one of the hedge fund industry’s biggest and most consistent performers. 

However, Citadel recently found itself embroiled in the controversy surrounding GameStop, the video games retailer whose stock was whipsawed by hedge funds betting against it and a horde of bullish retail traders loosely organised on the WallStreetBets forum on social media site Reddit. 

The fund stepped in to bail out Melvin Capital, one of the biggest hedge funds betting against GameStop. When Robinhood, a brokerage popular with the new generation of retail traders, was subsequently forced for regulatory reasons to curtail trading in GameStop, many Reddit users seized on a conspiracy theory that it was at Citadel’s behest. Citadel Securities — a separate high-speed market-maker also owned by Griffin — is one of Robinhood’s biggest revenue sources, paying it for the right to execute the trades of its customers. 

The firestorm led to Griffin testifying at the House of Representatives’ financial services committee hearing on the GameStop saga last month. Although Robinhood attracted the most ire and Griffin testified that Citadel had nothing to do with Robinhood’s decision, he did not escape unscathed from opprobrium from some Representatives.

Griffin largely shrugs off the controversy as a social media-concocted tempest stirred up by populist politicians. But he also argues that the saga foreshadows a wider, thornier problem of what happens when retail traders and passive index funds start to dominate more of the stock market, with prices becoming more detached from reality.

In US equities, passive funds are now roughly as large as the actively managed investment universe after a decade of rampant growth, while retail investors now account for nearly as much as all mutual and hedge fund trading combined. 

Griffin highlighted how an oblique tweet of a McDonald’s ice cream cone and a frog emoji from Ryan Cohen, a big GameStop shareholder, appeared to be the spark for a doubling of the stock’s price in one afternoon in February.

“The fact that the tweet of an ice cream cone can move markets will be the subject of academic study for years,” Griffin said. “It represents a dynamic where certain stocks are now almost exclusively owned by retail and passive funds. You’ve taken out active investors who focus on traditional metrics in valuing an equity.”

La voiture autonome est-elle une catastrophe pour la planète?

Annoncée comme un progrès majeur des décennies à venir dans le domaine des transports, la voiture autonome pourrait avoir des conséquences néfastes sur l’avenir. Une étude tire la sonnette d’alarme.

Certes, la voiture autonome initialement promise pour le début des années 2020 n’est toujours pas là. Les raisons du retard sont multiples (lire notre article pourquoi la voiture autonome est en retard) mais il s’agit d’un progrès technologique majeur, qui promet de faciliter la vie des automobilistes. Ce ne serait pas son seul argument : selon ses partisans, la voiture autonome pourrait avoir un impact bénéfique sur l’environnement. D’une part parce que la conduite par un robot serait plus souple et consommerait moins de carburant que la conduite par un humain. Aussi parce que la voiture autonome, en normalisant les situations de conduite, pourrait s’approcher du zéro accident. Par conséquent, les structures des voitures n’auraient plus à résister à des chocs et pourraient s’alléger.

L’argument écologique de la voiture autonome, une étude réalisée en commun par les associations La Fabrique Ecologique et Forum Vies Mobiles le balaie. Il apparaît difficile de chiffrer précisément l’usage et les divers impacts d’une technologie encore en suspens du fait de nombreuses inconnues techniques et juridiques. Mais les divers scénarios explorés par l’étude soulignent plusieurs points qui ont toutes les probabilités de plomber le bilan écologique de la voiture autonome. Cela commence par une multiplication des trajets, du fait d’une plus grand facilité de déplacement : on peut imaginer qu’à l’avenir, des personnes ne possédant pas le permis de conduire pourraient se déplacer seules à bord d’un véhicule autonome. Egalement, étant donné que le conducteur peut se concentrer sur d’autres activités que la conduite, les déplacements seront jugés moins contraignants. Voilà qui pourrait contribuer à une explosion des distances parcourues en voiture, avec évidemment un impact écologique et énergétique. Sans compter que cela pourrait contribuer à un urbanisme qui miserait sur l'extension des agglomération. Un cercle vicieux.

Un quantité de données énorme

L’augmentation de distance parcourue serait particulièrement significative dans les cas des robots-taxis (plus abordables a priori qu’un taxi avec chauffeur) et des voitures particulières autonomes. La Fabrique Ecologique nuance son propos pour les navettes autonomes, qui permettraient d’augmenter l’offre de transports en commun dans certaines zones. Dans ce cas précis, l’impact pourrait se révéler bénéfique, en se substituant avec des déplacements en véhicules particuliers. Malheureusement, selon Jill Madelenat qui a mené cette étude, "il n’existe pas de modèle économique viable pour la fabrication de navettes autonomes". Le marché serait insuffisant pour rentabiliser les importants frais de développement de ce type de véhicules.

Un autre point fondamental concerne la quantité de données nécessaires pour assurer le guidage d’un véhicule autonome. Celles-ci sont estimées à 1,3 million de Go par an pour la voiture d’un Français moyen. "Chaque voiture réclame autant de données que 3.000 utilisateurs d’internet !", reprend Jill Madelenat. Des propos qui rejoignent ceux de Philippe Watteau en 2018, lorsqu’il était directeur commercial du CEA. Il affirmait alors que les voitures autonomes nécessiteraient une puissance de calcul embarquée "non-négligeable par rapport à celle nécessaire pour entraîner le véhicule".

Des infrastructures à construire

Surtout, la voiture autonome nécessitera la mise en place d’infrastructures spécifiques, capable de dialoguer par exemple avec les feux de signalisation. Autant d’appareils qui ont un coût écologique de par leur fabrication, tant du côté de la voiture que de l’infrastructure. Voilà pourquoi La Fabrique Ecologique estime qu’une voiture autonome ne sera jamais, même si elle dispose d’une structure moins renforcée qu’une automobile traditionnelle, plus écologique à fabriquer.

Les nombreuses incertitudes ne permettent pas un chiffrage précis. Mais les divers scénarios envisagés par cette étude prévoient, du fait du seul biais de la voiture autonome, une augmentation de la consommation d’énergie du parc automobile multipliée par deux voire par trois. Et encore, cette intéressante étude ne prend pas en compte certains effets pervers. En effet, une des solutions envisagées pour les robots-taxis serait de les faire rouler à faible vitesse, même lorsqu’ils sont vides parce que le coût de l’énergie serait moins important que les frais de stationnement…

Vaccinating children will likely be necessary to reach herd immunity, experts say, but vaccines aren’t authorized for kids yet

Countries are racing to immunize adults against Covid-19 and move toward a more normal future. To achieve the vaccination rates that health authorities are aiming for, the shots must eventually reach the arms of children and teenagers, too.

Children aren’t going to be vaccinated for several months at least, however, because drugmakers are still testing shots in younger ages.

That means health authorities can’t be confident of securing community protection against the virus, known as herd immunity, until later this year at the earliest, because children under 18 make up a significant proportion of many countries’ populations.

“We definitely need to get kids vaccinated if we want to be as close to normal as we can,” said Octavio Ramilo, chief of infectious diseases at Nationwide Children’s Hospital, in Ohio.

As governments push to move past the pandemic, vaccinating children is emerging as a key obstacle, along with initially limited supplies of vaccines.

Researchers say between 70% and 85% of a population would need to be protected through infection or vaccination to achieve herd immunity, the point when so many people are immune that the virus has nowhere to go and even those who aren’t immune have protection.

“It’s hard to do that just in terms of numbers if you’re not going to vaccinate kids,” said Adam Ratner, chief of pediatric infectious diseases at Hassenfeld Children’s Hospital in New York.

Children and adolescents make up 22% of the U.S. population, according to the Census Bureau’s latest projections, and 18% of the population of the European Union.

Drugmakers first tested Covid-19 vaccines in older ages. As a result, the shots have been authorized only for the oldest teenagers and adults so far.

The shot from Pfizer Inc. and partner BioNTech SE is cleared in the U.S. for people 16 years and older, while vaccines from Moderna Inc. and Johnson & Johnson for 18 years and up. A vaccine from AstraZeneca PLC and the University of Oxford is in use in the U.K. and EU for ages 18 and over.

Pfizer has enrolled more than 2,000 children from ages 12 to 15 years in one study and expects to submit the data from that study to the U.S. Food and Drug Administration in weeks. The FDA could authorize use by the fall, Pfizer Chief Executive Albert Bourla said at The Wall Street Journal’s Health Forum on Tuesday.

Pfizer said Thursday it had begun evaluating its vaccine in children 6 months to 11 years.

Moderna is aiming to have its vaccine available for adolescents before the start of the 2021 school year and recently launched another trial with children as young as six months.

The University of Oxford is enrolling children ages 6 to 17 years in a trial of the vaccine it co-developed with AstraZeneca.

Clinical trials to assess the safety and efficacy of vaccines in children that have already been cleared for adult use can be done more quickly than the large-scale studies in adults that have already taken place.

The adult trials enrolled tens of thousands of volunteers, who were randomly selected to receive either the vaccine or a placebo. Researchers were then able to compare rates of infection and illness in each group months later to determine how much protection the vaccine provides.

For the adolescent and children’s trials, the focus is more on safety and measuring the immune response of the young volunteers with a blood test.

If researchers find the children in the study had a similar immune response as adults did, then the efficacy of the vaccines will likely be similar as well, said Robert Frenck, principal investigator for the Pfizer Covid-19 vaccine clinical trial at Cincinnati Children’s Hospital Medical Center and director of its vaccine research center.

Vaccines probably won’t be ready for use in younger children until early 2022, health experts said, in part because researchers need to test lower doses.

“The dose is not such a big leap to go from adults to teens,” said Katherine Luzuriaga, a pediatric infectious disease physician and the lead investigator of Moderna’s adolescent trial at the University of Massachusetts Medical School site. “Once we start going into the younger age groups, there’s a bit more work to determine the appropriate doses.”

Vaccinating those at most risk of severe illness and death has been the first priority of vaccination drives. In most countries, that has meant giving priority to elderly citizens and those with conditions that heighten their risk of severe Covid-19.

The rate of hospitalization is 35 times as high, and the death rate is 1,100 times as high, among people 65 to 74 years old infected with Covid-19, compared with children ages 5 to 17, according to the U.S. Centers for Disease Control and Prevention.

Health authorities say children don’t need to be vaccinated to start resuming certain activities like in-person learning at schools that are taking precautionary measures. Some experts caution against focusing too heavily on a specific herd immunity target, as building up population-level protection is an incremental process.

Children infected with Covid-19 overwhelmingly experience mild symptoms but can still get seriously ill on rare occasions and are able to transmit the virus to others.

More than 13,500 children have been hospitalized with Covid-19 infections in the U.S. alone, and more than 260 have died, according to a March 18 report from the American Academy of Pediatrics and the Children’s Hospital Association.

Contrarians see buying opportunity as investors drive yields higher on bets for rebounding growth and rising inflation

Robert Tipp doesn’t buy the popular Wall Street view that U.S. government bond yields are bound to keep rising this year, though he allows that they could before likely falling later.

The chief investment strategist at PGIM Fixed Income, Mr. Tipp is among a relatively small group of contrarians who have bet for months that the forces lifting bond yields—expectations for a post pandemic surge in growth and inflation, increased government borrowing—are no match for the structural factors that have suppressed them for decades.

Mr. Tipp’s position is notable because he and other so-called bond bulls have generally been right about the direction of Treasury yields over the past 30 years. That gives their perspective some added ballast as investors confront a set of highly unusual circumstances, including the possible end of a pandemic and an unprecedented surge in peacetime government spending and tax cuts.

The yield on the benchmark 10-year U.S. Treasury note, a key driver of interest rates across the economy, topped 1.7% earlier this month for the first time since the start of the coronavirus pandemic, settling Friday at 1.658%. That was up from 0.913% at the end of last year but down from around 5% 15 years ago and 8% 30 years ago.

Yields, which move in the opposite direction of bond prices, tend to rise when investors expect faster growth and inflation—which can lead to higher short-term interest rates set by the Federal Reserve—and fall when they anticipate a weaker economy.

Investors will get a fresh look at the strength of the pandemic recovery this coming week with the release of the monthly jobs report for March, as well as new data on manufacturing and construction activity.

Most investors believe that long-term factors, such as aging populations and lackluster productivity growth, have dragged on yields in recent decades. Even so, they are betting that inflation and rates are still poised to rise due to massive fiscal and monetary stimulus and the broadening distribution of coronavirus vaccines.

For longtime bond bulls, however, the last three months have been a buying opportunity, the latest of a string of episodes over the years when investors have too easily dismissed long-run trends amid a burst of economic optimism.

“When the economy recovers strongly like it is right now, investors push up yields, but a lot of times, actually most of the time, they tend to pass through fair value and keep going,” Mr. Tipp said.

Betting on Treasurys now isn’t without risks. Fixed-income investors wager on the direction of Treasury yields by adjusting a measure known as duration in their portfolios. Roughly corresponding to the time it will take investors to earn back the price they have paid for bonds, duration also indicates how sensitive bonds are to changes in interest rates.

As a rule of thumb, for every percentage point that a bond yield goes up or down, its price moves in the opposite direction by a percentage equal to its duration. Managers of fixed-income mutual funds generally don’t diverge too much from the average duration of a benchmark index. But they do try to outperform their benchmark in part by setting the duration of their portfolio a little above or below that of the index—with a longer duration often amounting to a bet that yields will fall and a shorter duration that they’ll rise.

In recent years, PGIM Fixed Income’s flagship Total Return Bond Fund has typically run a duration at or above its benchmark. That’s just a small part of its overall strategy but one consistent with Mr. Tipp’s view that factors like demographics and mounting private-sector debt would eventually pull yields lower, regardless of short-term fluctuations.

For the most part, the bet has paid off. Through March 24, the fund was in the top 24% of its Morningstar peer group, based on annualized 10-year total returns and only including the oldest share classes of each fund with a track record that long. This year, though, it is second-to-last out of 156 funds, losing 4.1%, according to Morningstar data, or about 3 percentage points worse than the average.

Another fund with a longer-than-average duration, Western Asset’s Core Plus Bond Fund, has had similar results. Its returns have exceeded its benchmark since Sept. 30 and put it in the top 8% of the same Morningstar group over the past 10 years but are last in the group this year at negative 4.3%.

John Bellows, one of the fund’s portfolio managers, said duration positioning is part of the fund’s diversification strategy, which includes relatively heavy investments in riskier types of debt like lower-rated corporate bonds. A longer duration offers some protection from economic slowdowns when riskier debt is at its most vulnerable but Treasury yields tend to fall.

The fund’s current position, however, also reflects his view that the “Treasury market is very optimistically priced at the moment.”

Specifically, he said, yields reflect expectations that the Fed’s benchmark federal-funds rate will remain near zero this year but start climbing at the end of 2022, then remain at 2.5% for about five years without causing inflation to fall below its 2% target. All of that, he said, seems ambitious considering inflation struggled to reach the Fed’s target for years before the pandemic.

For their part, Fed officials have pledged to be unusually patient about raising rates in the coming years. They have said that they want to see actual evidence that inflation can be sustained at their target rather than moving ahead of time, as they have in past economic expansions.

In their most recent projection, in mid-March, 11 out of 18 officials indicated that they thought rates would remain near zero through 2023.

Their median forecast showed annual inflation accelerating to 2.4% in the fourth quarter of this year and remaining at or slightly above 2% for the next two years. But Fed Chairman Jerome Powell has played down inflation risks, telling lawmakers recently that the effect on inflation from government spending will likely “be neither particularly large nor persistent.”

On Friday, the Commerce Department reported that one of the Fed’s preferred inflation gauges, the core personal-consumption expenditures price index, had climbed 1.4% in February from a year earlier. That was an unexpected drop from 1.5% the previous month.

Industry battles for survival as slow vaccine rollout threatens to delay reopening

María Antonia Llull’s Mallorca-based hotel chain is losing at least €1.5m a month, but she hopes this summer will be its salvation.

The coronavirus pandemic has shuttered almost all of its 30 hotels for months and the group, Hipotels, has put nearly all its 3,000 staff on furlough. Only its Cancún establishment — its sole hotel outside Spain — is open.

Llull is not alone: southern Europe’s tourist industry — a large part of the region’s economy — has been left in limbo as the slow rollout of vaccinations and the latest rise in cases make a second lost summer increasingly likely.

Easter might offer Llull a modicum of relief, bringing planeloads of German tourists to Mallorca, but it is the summer season that will be crucial.

“The Easter season is like coming up for air, before the water sucks you in again,” said Llull, who hopes to open eight hotels in Mallorca for the holiday. “What we need is the summer, because with another lost summer many businesses will disappear.”

Last year’s tourism slump wreaked devastation on the Spanish economy. Income from foreign tourists during the peak July to September season was down 78 per cent last year on the same three months in 2019, according to Bank of Spain estimates published this week.

In normal times tourism contributes about 12 per cent of Spain’s gross domestic product, so the collapse contributed to an 11 per cent economic output contraction last year — deeper than any other EU country. 

Although Spain is the centre of the crisis, the sector accounts for 11 per cent of southern European economic output and one in six jobs in southern European nations, including France.

These countries had already been hit harder than those in the north by the fallout from the pandemic and had higher debt levels, constraining their capacity to support struggling businesses and jobs, said Nadia Gharbi, senior economist at Pictet Wealth Management.

“The risk of another lost summer will only exacerbate these problems and put more strain on policy,” she warned.

Jacob Nell, head of European economics at Morgan Stanley, said vaccination programmes were not moving quickly enough: “There is a real risk that [European countries] have been so slow with the vaccinations that they lose another summer . . . That leaves the south of Europe at risk of further [economic] decoupling from the north.”

The Bank of Spain’s baseline scenario is that the economy will grow 6 per cent this year, aided by receipts from foreign tourists reaching 56 per cent of their 2019 levels. While it said that tourism and the economy could significantly outperform these expectations, the central bank also set out a “severe scenario” in which Spain manages only 3 per cent growth and tourism slumps even below 2020, to just 14 per cent of 2019 levels.

There are early indications that the recovery will be slow. Although Lufthansa’s flights from Germany to Mallorca are almost fully booked over Easter, it expects overall bookings this year to reach only 40 to 50 per cent of pre-pandemic levels.

Other European countries are also bracing for continuing economic damage. According to the Greek Tourism Confederation, revenues from tourism, which supports one in five Greek jobs, fell 77 per cent last year.

This year has so far proved equally grim: Greek hotel bookings fell 74 per cent year on year in February and internet searches for rooms fell 63 per cent, according to data published this week. Harry Theoharis, Greece’s tourism minister, recently expressed optimism for “a better year than last year” but admitted “bookings are depressed”.

According to analysts at Allianz, the European independent hotel sector’s sales halved last year, and will regain only a quarter of that decline this summer.

Goldman Sachs has forecast a sharp rebound in tourism, adding 1.4 per cent to Spain’s total output this year and 1 per cent to Greek output — but that assumes most restrictions are lifted by June. It warned of a downside scenario in which restrictions remain throughout the summer, knocking 1.3 per cent off growth across southern Europe.

The key is vaccination, which will help stem infections in both source and destination countries, and boost governments’ readiness to allow people to travel.

The EU aims to inoculate 70 per cent of adults by summer-end, though the tourism industry was alarmed by European Commission president Ursula von der Leyen’s remark that summer lasts up to September 21. By then, the main holiday season will be all but over.

Alan French, chief executive of Thomas Cook, said that although he had “no doubt that holidays will take place probably this summer, the point in time and the criteria they will have is what we are speculating on”.

“We have to generate confidence by the beginning of summer to get the season back,” said José Luis Zoreda, vice-president of Exceltur, a Spanish tourism industry group. “If that confidence only comes back in October, perhaps that’s OK from a health point of view, but for our sector it is a disaster. There are businesses that have been closed since October 2019 . . . What industry can survive two years without revenues?”

At present, however, the industry is facing more stumbling blocks. Germany ordered Lufthansa not to add any more flights over Easter and is considering a temporary ban on holidaying abroad after alarm at the number of Germans flying to the Balearics.

Britain — Spain’s largest source of tourists — is increasing curbs on foreign travel. Most UK travel companies expect it will re-employ last year’s traffic-light system, which designated destinations “green” or “red” depending on infection rates.

And Spanish authorities face domestic criticism for seeking to welcome EU tourists while imposing internal travel restrictions on Spanish residents.

“The main thing is that the sector has to get going again and it has to be sustainable,” said Zoreda. “If we need more restrictions now to do that, OK, but what we are calling for is for vaccinations to be accelerated.”

Meanwhile the Spanish and Greek governments have made contact with the UK in an attempt to agree bilateral travel deals if an EU-wide vaccination document scheme is not in place in time.

“We need to do everything we can to save the summer season,” said Llull. “If I was offered just half of the business we had in 2019, I would say: ‘Where do I sign?’”

Pension funds pay the price for bond market distortions

Interest rate moves raise questions about how scheme liabilities should be calculated

The recent fall in bond prices and consequent rise in yields will come as a boon to deficit-prone pension funds.

Future pension obligations are discounted by a rate derived from bond market yields. A rise in the discount rate shrinks those liabilities, and deficits also shrink in the absence of a material fall in the value of the fund’s assets.

The other big beneficiaries of the rise in bond yields are value investors. They have been bruised for years thanks to their lack of exposure to the big tech stocks that have driven equity markets to heady levels.

Discount rates played an important part in the tech stocks’ rise because the long decline in bond yields caused the net present value of the tech companies’ strong future cash flows to balloon.

Bill Gross, co-founder of the Pimco fund management group, has estimated that a drop of 1.5 to 2 percentage points in real long-term interest rates can boost the price of Apple or Amazon by as much as 50 per cent, other things being equal.

With interest rates now rising, the discounting logic goes into reverse, shrinking the net present value of the growth companies’ future cash flows. But the adverse impact of the rate rise for value stocks is offset by enhanced earnings prospects from the reopening and recovery of pandemic-hit economies.

Yet there is a tricky question to be asked as to whether the values thrown up by discounting at historically freakishly low interest rates make much sense. They are the product of a market that has been systematically rigged by central banks whose balance sheets have been stuffed with a multitude of government IOUs since the global financial crisis.

Today’s long-term gilt yield of 1.2 per cent compares with yields that ranged from just over 2 per cent to 6 per cent in the two and a half centuries before the financial crisis, according to A History of Interest Rates by Sidney Homer and Richard Sylla.

And in the parts of the global bond market where negative yields prevail, the concept of the time value of money borders on the perverse since the present value of today’s pension liabilities is greater than their value in the future.

The winners from ultra-loose monetary policy have been asset owners including, conspicuously, homeowners. But their gains have come at a political cost. The resulting wealth inequality has fed a populist backlash across the developed world.

This year’s rise in bond yields is an early warning of trouble to come. The exit from unconventional central bank measures will be infinitely harder than the entry because policy rates cannot be raised to address any looming inflationary threat without inflicting serious financial instability along with economic recession, or worse.

Central banks will now be under increasing political pressure to keep government borrowing costs low by extending their bond buying into longer durations and keeping interest rates from rising above a given target — yield curve control, in the jargon. That would point to more bubbles and, as long as actuaries and pensions regulators slavishly adhere to distorted “market” benchmarked discount rates, to continuing inflated valuations of pension fund liabilities.

This will be tough on sponsoring companies that have been pumping money into their defined benefit pension schemes to quell burgeoning deficits. And there are wider economic consequences because there has almost certainly been a reduction in risk appetite in boardrooms, which may have been a contributory factor in low rates of investment since the financial crisis.

There is an obvious, simple solution to this problem, namely historical averaging of the interest rates used in discounting liabilities to present values. Yet it is hard to make a case for what would be perceived as a loosening of valuation rules when pension fund scandals at British retailer BHS and elsewhere are fresh in the memory.

The irony is that the actuaries’ embrace of market fundamentalism is a recent phenomenon. In many countries in the 1960s and 1970s, they ignored market values when valuing assets and preferred instead to discount their own estimate of future pension fund income, usually at the same rate as they discounted the liabilities. Result: a magical balance whereby the value of assets and liabilities was immune to shifts in interest rates.